Money Market Reform (with Erik Sirri)

[0:00:00 Speaker 1] from the Salem Center for Policy at the University of texas at Austin. Welcome to an episode of policy and pieces. I’m your host scott, bogus.

[0:00:12 Speaker 0] And I think at some level, the banks have always had their eye on the asset management industry, Money market funds. They were bank like in what they did, they transformed assets. You took in a somewhat long term asset, 30 60 90 days that was maybe somewhat liquid and you issued a fully redeemable, infinitely liquid share. That’s very much a banking function. And so I think the bank regulators were always a bit, um, I don’t want to see envious, maybe covetous, maybe maybe had their eye on this business.

[0:00:44 Speaker 1] That’s Eric Serie. He was a senior sec official during the 2008 in 2009, global financial crisis. He talks to us about money market funds, what they are, how they’re used and importantly, their financial stability risk. They had to be bailed out by the Federal Reserve Bank in 2008. It happened again last march of the onset of the pandemic. Not surprisingly, the new administration is considering regulatory reform, but eric explains why a solution is complicated. There are market instrument falling under the jurisdiction of the SEc that are otherwise use like a banking product, the checking account that falls on the jurisdiction of the Fed and the two regulators. They don’t always see risk the same way my co host today is McCombs Vincent School student Jack chapman eric, welcome to the show.

[0:01:30 Speaker 0] Good to be here.

[0:01:32 Speaker 1] And also with me today is Jack chapman. McCombs Business School student Jack Welcome. Thank you. Good to be here. All right, so eric, it’s wonderful to have you talking to us today about money market funds which ostensibly are very simple financial market instruments yet seemingly so complicated when it comes to regulating them and in particular when it comes to financial stability, we think you’re the right person to talk to about this. You currently sit on the S. E. C. S. Asset management advisory committee. You had two tours of duty at the SEc. First is the chief economist. So Jack, where do you think we should start this interview? Yeah. Eric to start. Can you just tell us what attracted you to go to the sec?

[0:02:15 Speaker 0] You know? Um I have a PhD in finance and I was a professor at Harvard. And you teach finance and uh what the sec offered the teaching at a college didn’t offer was the chance to see how uh take what you knew and put it into effect in terms of policies. The SEc is comprehensive in the way it regulates securities markets so that was a fine place to be to do that. The sec regulates money market funds, mutual funds generally, but it regulates exchanges. It regulates issuers of corporate securities, so all of that theory, all of that empirical knowledge. You built up when you were a PhD student and you were researching when you were a professor, you had a chance to put that to use.

[0:02:55 Speaker 1] So eric you you went as a chief economist. That’s a that’s a natural fit for somebody is a Harvard Business School professor. But you came back as a division director of Trading and Markets and that’s generally reserved for somebody that comes from industry or industry practice. How did you end up in that position?

[0:03:12 Speaker 0] Yeah, it is. It’s usually reserved for an industry person and a lawyer. In fact, what was probably most unusual is, as you probably know, the sec is mostly composed of lawyers, the Division of Trading and Markets, which regulates exchanges, broker dealers, option exchanges, clearing settlement, credit rating agencies, all of that. It was typically a lawyer who ran that. I am not a lawyer and I think it just happened because the chairman at the time chris cox was looking for some solutions that were not necessarily based in law. He was looking for a framework that was more economic, more financial than legal for some of the issues he was facing. And so I ended up being the person who was selected.

[0:03:55 Speaker 1] How was it working with lawyers? Did you develop any new appreciation from that situation?

[0:04:01 Speaker 0] Well, I did. You know, lawyers are very hardworking. They’re very rigorous. They’re very thorough in their work. Not being a lawyer. There was a lot to learn on the other hand, not being a lawyer, relieved a lot of stress because usually the person in my job was the smartest lawyer in the room being a non lawyer, no one expected me to know the ins and outs of the statutes or the laws so it could focus on the economic content. And I I ended up with a lot of respect for the attorneys I worked for. They were very smart people. They were very good at thinking through issues. But again, they thought mostly from a legal framework as opposed to an economic or financial framework,

[0:04:37 Speaker 1] why do you suppose that there are still very few of you in that position? It’s reverted back to attorneys and lawyers and it’s time for another economist to go back into that position.

[0:04:47 Speaker 0] I think it’s because the sec administers the law. And so, you know, without getting into the details, there’s there are these laws that were written in the 30s and 40s that described how our markets should be regulated and yes, rules have been created since then. But in the end, the sec administers law and a previous chairman has called it primarily a law enforcement agency. Usually when you think of law enforcement agencies in the administration of law, you look to lawyers that said, I think there are benefits that come from having an economic viewpoint embedded within the commission, Whether you want to make it the head of an agency or a deputy head of a division or a deputy, that’s that’s up to the chairman.

[0:05:28 Speaker 1] Okay, So we’re gonna talk about money market funds today and in particular is a lot of chatter about the need for money market reform. But I think a good place to start is to wind all the way back to the financial crisis and get the right perspective on the risks that persist in this area of the markets. And I thought we might start with a former porter J of yours, you were the confidence of the sec chair during the financial crisis and you had somebody working for you by the name of dan Gallagher at the time, he was your Deputy director, he went on to be an sec commissioner and is now the chief legal officer at Robin Hood, which in itself is getting a lot of attention these days

[0:06:07 Speaker 0] that it is. And

[0:06:08 Speaker 1] he came on our show and he and he had a few things to say in particular about you. And if you’ll indulge me, I’d like to play a clip, eric Siri came into my office and uh he’s one of the more brilliant guys that you’ll ever meet. He was literally literally a rocket scientist, PhD economist Harvard Business School professor. Now he’s at babson and he’s just one of those guys that, you know, nothing really gets to him, he’s sort of unflappable. And he said, oh man, that was crazy. And I said, what? He said, I just got back from Capitol Hill, I was there with Paulson and chris and Bernanke and and he said it was just wild because Bernanke said, this is the worst thing since the Great Depression and could be even worse. So that was his recollection of when you came back from Capitol Hill after the deliberations that were going on at the time of the Lehman failure, I don’t know if that was right before or right after. Do you remember that time? Do you remember what was going on?

[0:07:12 Speaker 0] You know, I’m not sure, I remember the details, but I think it was related to something called tarp and the idea that there needed to be an injection of capital into the financial system to uh, stop a further decline in asset values and the collapse of certain elements of our financial system. And that was, that was not a popular thing. If you remember the history back then in 2008, the first time the first pushed through that did not go through, it took a couple pushes to get Congress to free up funds to inject into the financial system. And to this day, that remains a very, you know, politically charged event for a lot of people who think to this day, that should not have been done. It was not popular from a populist perspective.

[0:07:54 Speaker 1] Where was that in context of the Lehman failure? And maybe, can you just describe, can you remember what it was likely enough to Lehman? Mhm.

[0:08:04 Speaker 0] You know, leading up to Lehman At the time, we had, we, the United States had five big investment banks, going back to say, 2007, and those banks, and have been in existence for a long time. They were traditional investment banks and importantly, they were not part of commercial banks. Getting into early 2008, you saw the collapse of bear stearns and Bear stearns collapsed for its own reasons. But part of it was related to funding. It couldn’t get funding in the institutional markets. It held assets on its balance sheets, like subprime mortgages, that were thought not to be, you know, worth what they were booked for. And so the firm collapses. You’re now down to four investment things. And they were at the time, there was a perception that there were stronger in weaker Investment makes amongst those four. And as markets continue to deteriorate throughout 2008, investors moved from what they perceived to be the weaker banks toward what they perceived to be. The stronger banks. That’s the stronger banks were, had an easier time finding funding and the weaker banks had a tougher time finding funding and Lehman was certainly on the edge. One of the firms that were perceived that was perceived to be less strong. So you were

[0:09:21 Speaker 1] presumably one of the chief confidence to chairman cox at that time and be an economist, I’m sure helped. Can you describe what it was like to be in the room and those discussions, were you in those discussions that are often written about and talked about in the press and popular books?

[0:09:38 Speaker 0] You know, there are a lot of, there were so many discussions that were, had, some of them were had at the sec, but a lot of them were had in new york, they were had at the Federal Reserve. The thing you have to remember is that when these firms, when these investment, thanks the Goldmans, the murals, the morgans and such, the lemons as they became challenged financially. An entity like the SEC is a regulatory agency, can only provide a limited amount of help because it does not have access to capital, it does not have a credit line. And so those firms became much more interested in what the Fed in particular could do for them. And so a lot of the discussions focused in new york for that reason,

[0:10:20 Speaker 1] what was it like to be in the room with all these decision makers? Is there any particular anecdote that stands out to you 10 years after the crisis?

[0:10:31 Speaker 0] You know, it one thing I will tell you that I remember. So, so these were all very sensible people. They’re very well prepared for what was going on Hank Paulson in particular? Uh, There are two people talk about when is hank Paulson? One is Ben Bernanke. So it was interesting about hank Paulson is that he was the Secretary of the Treasury, He grew up with the other heads of the big banks and investment banks. They were his peers. So it was not the case of the Secretary of Treasury being a long term Washington bureaucrat in this instance, the Secretary of the Treasury was a peer of the people who, who’s firms were being cast around by the all the turmoil in the markets. So he knew these people personally, he knew their firms intimately and he had a way of negotiating and communicating that I think couldn’t have been replicated by someone who grew up in the halls of Capitol Hill or you know, on K street. It just that wasn’t going to happen. So, in many ways, I think we were fortunate to have Paulson. Bernanke was a very different kind of person in many ways, he was the most impressive person. I think I saw during the financial crisis when we would have big meetings, you know, frequently, senior staff like heads of agencies would bring underlings with them just because they couldn’t know all the details I can remember many, many times. Bernanke would just come by himself, he would sit at the table and if there are questions, if there was a question, he would just hold forth in the most cogent, compact manner, because he had comprehensive knowledge of the issues that were involved based on this past research. So here you have this individual who’s the head of the world’s most powerful central bank in the middle of this crisis, in the one thing that was eminently clear is he understood what was happening. He understood what was important, he could express himself. And, you know, I think as a country, we were lucky to have that guy running the Fed at that time,

[0:12:25 Speaker 1] after getting the opportunity to work directly with all these brilliant people and and working through the crisis, did you learn anything about markets that you didn’t previously know before?

[0:12:34 Speaker 0] Oh, I learned a lot about markets. So I’ll give you one example, our big banks like the Lemons and the morgans and the Meryl’s, they funded themselves largely in wholesale funding markets, by which, I mean, repurchase markets. And while while it’s, it’s an institutional form of financing where a big broker dealer, like a Merrill or a morgan would come and say, we’ve got a bunch of securities on our balance sheet, but we need more money so they would off lift those securities off the balance sheet and give them to some other entity. We can call it a money market mutual fund if you want. And in return, the money market mutual fund would give them cash. So it was like a secured loan. That process, that transaction is called a repurchase agreement. And they were, they were a primary means of funding these big investment banks. One of the things that happen and they were very stable. We’ve been funding investment banks this way for decades and decades. One of the things that happened, it was especially highlighted by bearer in February and March of 2018 is that funding just walked away as investors became concerned about the viability. These firms, you saw these big investment banks lose the ability to fund their securities positions through repo and that money would walk away to the tunes of, you know, tens of billions of dollars in a weekend. And I had never seen or thought I would see money run out the door that quickly in a traditional funding arrangement. It was breathtaking to behold. So yeah, sure. There are many, many things I saw there. Um second thing I saw that I never thought I would see is relates to something that’s not the topic of his podcast, but I’ll mention it, it’s short selling. So related to short selling. It happens when investors take a security, they don’t hold, they borrow it, then they sell it short and this is done to express a view that they think that security is going to go down well. Typically big firms, big banks, big broker dealers are very much in favor of short selling. They make a lot of money doing it. They made a lot of money financing it. They make a lot of money lending securities in that business. As the credit crisis war as that crisis wore on, the heads of the big banks came in and we’re pleading for us the sec to restrict short selling that is to take our free markets and make them less free. And that was a remarkable thing because typically the heads of these big banks are very much in favor of the government’s staying out of markets. Here is an instrument instance where they wanted not only the governments to step into markets, but to restrict what is a traditional free market activity, which is the ability to buy and sell stocks. That will, that was not something I thought I would ever see

[0:15:20 Speaker 1] since you brought it up. I believe that chris cox after the fact said or regretted that decision having been one of his biggest mistakes and that there should not have been short sale ban of financial stocks, that I get that right. Do you have a similar conclusion?

[0:15:37 Speaker 0] You know? Yes, you did get it right. I think chairman cox after the fact, you know, he was very concerned about it in the moment. And you know, reflecting back, I think he felt that that was probably the biggest mistake he made, was to allow a ban of short selling, a very broad band of short selling and end. You know, it’s a it’s a, I can remember very well, us doing it when you have a financial or financial economics view restricting something like short selling very much goes against your grain. Yet in the moment, the sec was being pressured tremendously. Bye. Various people, by congressman, by senators have a recollection of Senator McCain saying that cox was failing to do his duty by not because he didn’t restrict short selling and that the first thing he would do when he was president would be to fire him because of that. So the sec was under a lot of pressure to restrict short selling and it did it for a period of time. I don’t think it was its best choice. I think the analysis that’s come out since then shows that, look, the short sellers were not the cause of the problem. If anything, they were a mechanism to cause what was fundamentally wrong with these firms to be reflected in prices.

[0:16:58 Speaker 1] So to continue with our seg, um, were you impressed? The sec did not ban short selling during the height of the covid pandemic?

[0:17:06 Speaker 0] No, I don’t think I was impressed by it. I would have been shocked had they done it? I think you know, it was done in 2008. It may not have been their best choice, but I I think it will be a long time before they make that decision again.

[0:17:21 Speaker 1] Okay, let’s shift to a money market funds. That is the topic of the day. And maybe you can start and you did a little bit this already. Can you just tell us when a money market fund is, how do they work? He uses them and what makes them so fragile?

[0:17:38 Speaker 0] Well, you know, look, money market funds are terrific because what they do is they give you as a let’s just talk about retail investors as a retail investor away to earn market rates on your deposits. So sure you could put money in a bank. That’s a typical thing we do. But bank rates are not always market rates for various reasons. By going onto a money market mutual fund, which is a mutual fund that holds nothing but very short term high quality debt. So this is debt that could mature in one day or maybe it might mature in 60 or 90 days but holds very short term debt. It lets you put your dollars or $10 or $500,000 in a fund. It will be in principle safe and it will be liquid in that. You can get it back on a day’s notice. These were created in response to certain regulations that applied to banks when they were interest rate ceilings. Money market funds are offered are able to offer market rates where banks rates at least in the past, had been capped and they’ve been very successful typically over time as a financial product.

[0:18:48 Speaker 1] So there’s a feature of money market funds as the central feature that contributes to their fragility and that is something called a stable nav. What does that mean?

[0:19:02 Speaker 0] So, you know, if you own an equity mutual fund, you’ll see that you’ll know it buys stocks, say, and every day that price of that mutual fund fluctuates. So it might be $10.87 today and it might be $11.02 tomorrow. Unlike that equity fund, a money market fund has a price per share of a dollar. It is pegged at a dollar. And the reason why it can do that is because the assets, it holds a relatively stable, they’re stable because they’re short term and they’re stable because they have high credit quality. Yes, they could move small amounts as rates change or credit quality changes, but through a bunch of technical aspects of the rule, the fund is able to mark them at a mark the funds nab at a dollar in those very small variations are basically subsumed by the penny pricing, so to speak that’s associated with a money market mutual fund in net. What it makes it appear is that it’s cash because a share of the fund is always worth a dollar. And I think that was one of the key design features of money funds that made them successful

[0:20:12 Speaker 1] during the financial crisis. That wasn’t the case. They turned out not to be cash. And why was that?

[0:20:16 Speaker 0] That’s exactly right. They turned out not to be cash because the intermediation function that money markets funds perform did not always work. So the reserve primary fund was the fund that probably the most notably associated with this. This was a large money fund, Maybe $60 billion dollars worth that held Lehman commercial paper. So this is short term I. O. U’s. Issued by Lehman, the bank that would later default as that bank got into trouble. And as that bank declared bankruptcy, Shareholders in the Reserve Primary Fund, which held about $800 million Paper, lost faith in the notion that the value of their assets in that fund were even close to a dollar. And when they lost faith, they started pulling their money out of this fund. And when I say pulling their money, I don’t mean taking $10,000 out. I mean institutional players pulling a billion dollars out and giving you hours notice. So we’re talking within the day redemptions of a billion dollars, maybe more to fund those redemptions. That money market fund had to tender cash to those shareholders who wanted their money back. But to get that cash, they had to sell the commercial paper, the government securities, whatever it was that they owned. And in the end it became very, very difficult for them to sell enough paper, enough commercial paper, enough assets to fund those kind of redemptions And that fund had to see the redemption feature was terminated and that fund declared itself to have a value per share of I think 97 cents and thus broke the buck, Which is the phrase that’s associated it was no longer with it. Worth a dollar per share was now worth 97 cents. For sure.

[0:22:13 Speaker 1] At what point, relative to Lehman? A. I. G. Did money market funds really start to grab the attention of the sec.

[0:22:20 Speaker 0] You know, I think we were always cognizant of money market funds because they were the way they were intertwined in the financial system. So I headed the division of trading and markets. The way we were cognizant of them is their role in repo and funding those markets. So those funds, those money market funds, because they invested in repo they held securities that were issued by or that were owned by the big investment banks. So we were always very cognizant of that. I can’t say sitting in trading and markets that I had ever heard of, the reserve primary fund. Other than maybe in the history book, because it was one of the first, it was, I think the first money-market fund. But other than that, that wasn’t a name. I thought about until it came to the fall of 2008.

[0:23:12 Speaker 1] How much attention did money market funds get relative to the other

[0:23:16 Speaker 0] issues at the time? You know, If you mean in September 2008, then? Well, they got a lot of attention, but by then you had the structural flaw, the structural aspect of them where they guaranteed this infinite liquidity, if you will, you could get all your money back. Same day, that feature of them became problematic because of the quality of the paper they held. And so at that point, the tools available to the sec were quite limited. We only wrote the rules. We didn’t have a wallet where we could lend money broadly throughout the financial system. So at that point, the focus turned to entities like the Treasury and the Fed, which was what that’s what was needed to repair the shortcomings in the financial system. The work of the SEc continued after the financial crisis as they thought about how to patch up or shore up the regulatory framework of money market funds. But in the moment, there was very little meaningful that the SEc could do if you wanted to rescue the positions of those funds because what it really took was money.

[0:24:20 Speaker 1] So we’ll talk about the reform in just a second. But before we get there, I want to get your view if you have one on what the real time response to the SEC was and I realized this was in a sister division of yours, an investment management. But like what is the real time response? Do fund managers reach out to the SEc and say, hey, we need to suspend redemptions. They need to get approval. Does the SEc call fund and say, hey, how you guys doing?

[0:24:44 Speaker 0] So? So it’s a good question. I don’t want to speak for another division, but I can certainly give you my impressions in a moment like that. You’re very much in touch with your industry, that your regular duties in the industry. So it would have been my expectation that the staff of the Division of Investment Management would be in touch with all the big providers of money funds, the Fidelity’s, the Federated, the big funds that they would understand their positions, that they would be tracking the redemptions, their liquidity positions. I think that, you know, once once, you know, we got to this point, they were very much on top of that in the same way that in the division of trading and markets we would be conscious of the positions of the big investment banks and large broker dealers. You just needed to be that that was just part of the job and part of what what the division did.

[0:25:31 Speaker 1] So what is it like from the chairman’s point of view and triaging all of this? So you you have multiple emergencies going on and they all get channelled up through various divisions and offices and decisions have to be made. How do you think the governance worked during that period of time? Within the Chairman’s office, the commissioners and the various office and divisions?

[0:25:52 Speaker 0] You know, I don’t recall there generally being much sort of strife in the sense that some commissioners were pulling right, while others were where others were pulling left. I don’t recall that what my recollection is. It was just so hard to get a valid information. People were starved for information. You were trying to get current information on what was happening today. And the financial picture for firms or money funds was changing day by day, just in terms of their own traits, as well as things that other agencies within the federal government was we’re doing so. It was very, very difficult to build up a comprehensive picture. The chairman was probably the one who is most plugged in and most at the center of that all because of the way the commission is organized. But that left the other our job would be to keep the other commissioners who also had votes apprised of what was going on. And so there was a constant battle to keep people up to date so that they would have good information for the decisions they need to make. That’s very difficult to do

[0:26:49 Speaker 1] so after you left In 2010, the sec implemented a first phase of reform and I think most notably It required funds to reduce the weighted average maturity from 90 days to 60 days of securities held. Do you think those reforms would have made a difference in 089?

[0:27:11 Speaker 0] You know, I don’t think I do, I don’t think they would have really made a difference. Because why would you want to reduce the weighted average maturity? Well, that’s because and if you’re comfortable fixed income terms, it would shorten the duration of those instruments. That would mean they would be less sensitive to interest rate changes. It would generally make them more liquid. So. So while that’s maybe a sensible thing to do with respect to the issues that were at play in 2008, no,

[0:27:38 Speaker 1] 60 Day paper would make a difference from 90 day paper for Lehman.

[0:27:41 Speaker 0] Uh, no. If it if it was worth 0, 90 day paper is worth at zero, is worth just about as much as 60 day paper at zero. Yeah, I I don’t think it would have haven’t had an effect. That doesn’t mean it was a bad change to make. But no. To your question in 2000 and eight, it wouldn’t have made any difference.

[0:27:58 Speaker 1] Okay, Another question I have. And the reform also required fund advisors to periodically stress test their funds. This has also become somewhat popular, particularly among european regulators, that you need to do periodic stress testing to understand the sensitivity to potential shocks. And the question I have for you is is that a good regulatory approach to have fund managers do stress testing, and in particular, do fund managers have the right skill set and sophistication to do that? Is that a reasonable expectation?

[0:28:31 Speaker 0] You know, it’s a good question. So, stress testing for funds is not today, not restricted to just stress testing associated with issues in money market funds. We stress test for liquidity and long term funds. We do other kinds of stress testing. And and is it a good idea for them to do it? Well, you know, they are after all running these funds are sponsoring these funds so it’s probably a pretty sensible idea for them to have an idea of the risks that they’re managing. That I’m sensing behind your question. You know, maybe it’s the notion that are they the right people? Are they equipped to do that? Do they have the right background? You know? That’s hard to know. Um, hopefully they built it up over time. I will tell you that a business has arisen for certain amounts of these kind of tests to be performed by 3rd parties. So you can get third party consultants to come in and I think assist you with some of this. But um look, these stress tests are only as good as some of the assumptions that you make. So, for example, you may stress test a fund and say, let’s assume that rates climb overnight by 200 basis points. Okay, well, you can probably pretty readily value in terms of theoretically what it does to your portfolio, much more difficult to model what it does to investors behavior and what the liquidity the market is if you have to sell. So I think it, it helps, but I don’t think it’s the be all and end all.

[0:29:54 Speaker 1] That’s a good point. And it reminds me another little segue here of the Robin Hood episode where it seems that there was a deviation from the var models that were used for margin determinations and they were turned off. And then there was some sort of haircut method where all of a sudden margin requirements went up. And so I don’t know if that’s an artifact of we no longer trust models and we go to more human decision making during periods of volatility. Is that a related issue? Is that persists now?

[0:30:25 Speaker 0] Well, you know, I mean, in the end this margin exists to make sure that the right people are getting paid given the promises that they made. And, you know, one thing that happens is when things get tough, when markets get stressed, everybody wants their money back or everyone wants control of their money. And if you’re running a certain kind of model, and that’s the traditional model, you’ve you’ve run and you get worried because of volatility is very high. In the, you know, in March 2020 volatility climbed to over 80. The vics was over 80. When those kind of things happen. People get very concerned about getting their money back claims to their money and they’ll change ad hoc rules. And that’s certainly one of the things that we’ve learned over time. So if the rules of the road are one way and that’s how things work in quiescent times, you shouldn’t be surprised when your counter parties are business partners change the rules of the road to their favor, when times become less favorable. I think we’ve seen that a lot.

[0:31:22 Speaker 1] So also in 2010, there was a president’s working group report aimed at broader money market reform. Can you describe this little bit and also tell us what the PWG is and why it’s important?

[0:31:34 Speaker 0] Sure. So, you know, one of the things that’s true about the United States is, and isn’t true about a lot of countries in the world, is that our financial regulatory system is fractured. I’m not, maybe I’m being a bit pejorative, but it resides in many places. For instance, you’ve got a central bank and it regulates certain banks, but not all banks. You’ve got an office of the comptroller of the currency that regulates the other banks. And then there’s a federal deposit insurance corporation, which also regulates banks. And that’s just the banks. Then you’ve got someone who regulates securities, then you’ve got someone that’s the SEc. Then you’ve got the CFTC who regulates derivatives, especially those, well, those that are not securities. And then you’ve got a few others tossed in there. So you’ve got all these financial regulators playing in the space and it’s still the financial system. So they have to work in concert in the President’s working group, or PWG was one of the entities put in place to try to get those folks to work in concert on issues where everybody’s position mattered. And, you know, that that group persists to this day. It’s members are Treasury Fed Sec, C F T C zero cc. Those are the people who are at the table.

[0:32:50 Speaker 1] So how does an independent agency like the SEC participate in and ultimately respond to a report like the PWG s?

[0:32:57 Speaker 0] Well, there’s a lot of negotiating that goes on going on around. And I think, you know, you have to appreciate some of the politics that are that’s behind this. A lot of the players at the in the PWG, our banking regulators and banks are big in this country, so they’re very, very important. But in a large fraction of assets in our economy are not under the bank regulator purview. And that’s the asset management industry. And I think at some level, the banks have always had their eye on the asset management industry for a couple reasons. One, it’s a lot of money to the entities that ran that business. A lot of them were not banks. They were things like Fidelity and Vanguard and other big asset managers. And look, these are big chunks of money. And when there were things like money market funds, they were bank like in what they did, they transformed assets. You took In a somewhat long term asset, 30, 60, 90 days, that was maybe somewhat liquid and you issued a fully redeemable, infinitely liquid share, that’s very much a banking function. And so I think the bank regulators were always a bit, um, I don’t want to see envious, maybe covetous, maybe maybe had their eye on this business. And you know, paul Volcker, I think was was one of those, I mean, it goes back a long ways where they saw these assets, they saw these, you know, this transformation went on and they saw it as being bank. Like

[0:34:20 Speaker 1] that’s a, that’s an interesting point you bring up and I think that, and maybe it explains something that they’ve often proposed a solution called capital buffers and we’ll get to that in a moment. But first, let’s start with what the sec ultimately did. I think it was controversial given all the various options that were put on the table by the PWG and some of things that were advocated. But ultimately, they required that prime funds float their nav and government funds could still offer stable nav. So they seem to have split the difference with respect to the problems. And do you have a view on that? Can you explain how that works?

[0:34:59 Speaker 0] Sure. So they’re, in a way, there’s two kinds of money funds and they’re grouped by the assets they hold. One is, as you said, a government fund which holds things like Treasuries or Agency Securities, it may hold repo and so these are very short term, very high credit quality instruments. So those are, those are quite safe as as funds. The others are what are known as prime funds. So they those funds hold typically commercial paper may hold the negotiable certificates of deposit bankers, acceptances, other things, short term assets that are more risky. There still there still relatively high credit quality, but an IOU from General Motors is not quite as safe as an IOU from Uncle Sam. And so there is a little bit more risk there. And so what happened is we floated the knave for those funds that held General Motors type Assets I’ll use from General Motors, but we allowed the $1 knave to stay in place for funds that only held short term Treasury instruments.

[0:36:01 Speaker 1] So the economic rationale is that money fund investors are going to run away from Treasury Securities. They usually run to them. So if you have very safe government Securities and Government fund, then we shouldn’t worry about offering a floating, nah, but for everything else, it should be floated because of the risk.

[0:36:16 Speaker 0] Exactly. So, so if you get worried about the financial system, you’ll see Treasurys rally in price, their yields drop, their yields may even go negative. And that’s analogous to people running into a full faith and credit us Treasury money market fund, that kind of an instrument that’s where people want to go. And they want to, relatively speaking, they would like to run away from a short term bond fund or a maybe a prime money fund. They want to get out of those because they’re a little bit less risky. And, you know, it just speaks to the point that investors and money funds, they tend to be very sensitive to credit losses. They’ve got their money parked there for some reason. They’re not usually investors in the same sense. You and I are investors when we buy an equity fund or a bond fund, they’re looking to keep their assets liquid and they’re looking to preserve their capital and they’re not, the last thing they want to do is take a credit loss on their investments.

[0:37:12 Speaker 1] So I have a question that may not be a fair question, because you’re only one economist. But if you had asked 100 economists to rate this decision, would the majority of them have agreed with it?

[0:37:24 Speaker 0] Well, you know, you know, the interesting thing about that is if you had 100 economists, I’m not sure they would agreed in the first place to, to create a fixed knob. Right. They would have said, well, it’s fine to have a, you know, high quality paper and issue a claim against it like a typical money market fund, but why do we need to create a $1? Let’s let’s maybe floated to begin with. But that’s not how the world evolved for very, a lot of reasons, including business reasons, we did have this $1 now. No, I don’t think everyone would have necessarily agreed with that. People had different views and that’s because the effect of floating the nav cause other changes within the system. People, people change where they wanted to put their money. There were some small tax effects that were at play here. So there were, there were other institutional effects that arose from floating the naff. But you know, the decision was made and I think in retrospect, I think most people think it was sensible.

[0:38:19 Speaker 1] So the sec also impose something called fees and gates liquidity fees and gates for the floating nav funds. And but what are fees and Gates and why were they included?

[0:38:31 Speaker 0] Sophie’s and Gates are a technique to try to Stem one way or another a run or to try to cause the effects of the run to be more limited. So the idea of a fee is that if the fund is, you know, sort of suffering in terms of liquidity, it’s still solvent, it still is worth a dollar. These funds have the ability to Put in a fee that says 1% 2%, whatever it’s going to be, that when you take your money out, you have to pay an additional fee and that fee goes into the assets of the Fund. So the idea is that it would both stop investors from potentially removing their assets and if they did remove their assets, there would be those fees would be placed into the fund. The idea of a gate is exactly what it sounds like. You know, if your model is that investors can come and go into this fund, that will one day by the next day sell, when you shut the gate, you’re limiting investors to get their money back and you, you say, yep, You know, we’re going to stop today and you may have $100,000 in this fund, you cannot get your money back, you cannot redeem your shares in some form or the other. So those, those tools are put in place to stop runs now. They may have other effects as well, but the idea behind them is they’re, they’re put in place to stop our limits. The deleterious effects of runs

[0:39:59 Speaker 1] Leading up to these rules going to effect in 2016, there was a massive $2.5 trillion dollars shift from prime funds to government funds. And you expect this. And why do you think the industry is so fond of the stable?

[0:40:14 Speaker 0] I I think, yeah, I think we did expect it because because even when I remained at the sec, we had conversations about this question and I can recall treasures of large corporations coming in and saying, look, you know, we’re not going to be able to get our paper funded in these markets because we we, you know, we were on both sides of this. A firm like, you know, just any industrial firm, they may they may issue commercial paper on the one hand, but they may be investors in money market funds, institutional money market funds on the other. And they did not want to see a floating nav Because in their mind, it meant their money was at risk. Now their money may have been at risk anyway, but when the knave could float and might not be worth 1.0000 anymore, but could be worth .9992. They saw that as risk to their capital and they had less interest in keeping their funds there.

[0:41:12 Speaker 1] What were the consequences to issuers of commercial paper, who typically relied on the prime funds for short term funding?

[0:41:20 Speaker 0] Well, I the market share of those, those types of funds declined, so there were fewer prime, once those rules went into effect in uh I think they went to effect in 2016. Once that happened, then assets declined, assets in prime funds declined and assets and government funds increased. So people invest whores who had previously in prime funds, now that they were floating their assets. They prefer to keep their their funds in in uh government funds, which stayed at a dollar not fixed.

[0:41:54 Speaker 1] So, in 2017, after the reform was implemented, the fr the Office of Financial Research issued a report on what they thought was a troubling development. So the prime funds shrunk. A lot of banks couldn’t issue commercial paper he purchased by money market funds. So instead they were taking loans from the Federal Home loan bank who wouldn’t in turn offer securities that were sold to money market funds. In essence, the Federal Home loan bank became an intermediary to solve perhaps an unintended consequence of the reform, and because of the basel committee liquidity coverage ratio rules, those were high quality liquid assets from the banks point of view. So that worked well from a capital point of view and the old far, I thought this was a financial stability concern putting a government like entity as an intermediary to solve this problem. Do you, do you have any thoughts on that? Do you think it’s a concern?

[0:42:53 Speaker 0] Well, you know, I I’ve not looked at the balance sheets of the federal home loan banks, but if you’ve got look, the money funds are inter mediating to begin with their inter meeting commercial paper against, you know, fully redeemable, you know, infinitely liquid share. That was shown to be somewhat problematic. So now you put someone in the middle and that someone in the middle is a federal home loan bank. But that doesn’t mean the basic problem has gone away. It’s just in the story that you’ve told, it’s sitting for the most part with the federal home loan bank. Someone has to ask themselves, what are the resources, what are their ability to withstand the kind of shocks that we know can hit these wholesale markets? And you know, I I don’t, I can’t, I haven’t analyzed the balance sheets of federal home loan bank and their ability to withstand these shocks. But, you know, it’s someone someone ought to pay close attention to that because I think at least has the potential to be a concern.

[0:43:46 Speaker 1] So let’s, uh, let’s fast forward a little bit. Let’s talk about more contemporaneous events. Let’s dial back a year from today and go to the onset of the covid crisis. Someone suggests this was our first real test of a lot of the reform that came out of the global financial crisis. And when it comes to money market funds, at first blush, it seems to have failed. The Fed launched money market fund liquidity facility, just like it did following the global financial crisis to help meet redemption demand, particularly in The prime funds. So what went wrong with the 2015 reforms?

[0:44:26 Speaker 0] Well, I mean, you know, it is interesting that it happened, and what I think what we know is that simply floating the knave was not enough right? That that was not enough to do it when people became concerned about the liquidity in the market. You know, the paper, the spreads on paper. So this is the commercial paper that was purchased by the Prime fund blew out so that it increased by hundreds of basis points. So people perceive the credit quality of the underlying issuers is being diminished. So that’s a trade of the of the of the these firms liabilities in the first instance. And at that point, you you were saying that that implied losses in these prime funds And as a result, you know, the Feds off, I mean, funding funding disappearing here in these markets, locking up and they were forced to come in and provide liquidity as they had in 200 and 2008. And I think, you know, you got to sit back and say, well, you know, at some level, the reforms were not completely effective because if they were in a perfect world, you might have seen the prime funds just take their, take their hit From, you know, .9999 or whatever they were at down 2.96. And everyone, you know, it’s all reflected in the price and liquidity remains in the market. That’s pretty clearly not what happened.

[0:45:46 Speaker 1] So, why, why did the Fed do that now? Prime funds this time had shrunk from over two trillion to 500 billion. From a financial stability perspective, There was, I think, about a $50 billion 10 drop in assets under management. Was that a financial stability concern that needed to be addressed? Or could they have let it run a little longer to see how effective the 2015 reforms could have been.

[0:46:15 Speaker 0] So, that’s a great question. The trouble is, there’s a counterfactual world we don’t deserve, which is what happens if they would have let it run a little longer. So it might have been that it was all fine, right. It truly may have been that it got reflected in the price liquidity returned, albeit slowly, and that, um, firms issued less commercial paper or they issued it at higher spreads. All those things could have happened. I think there’s a natural risk aversion in these kind of situations, on the part of central regulators, because you’re playing, you know, you’re taking chances with something that’s pretty important and the spillover effects can be pretty market. So had they done this, you might have found yourself in a world where even the government only money funds were in peril. Now, that wouldn’t have been necessarily very logical because they held full faith and credit paper. For the most part, it was short duration. But look, we’ve seen spillover effects in other markets at other times. I mean, the one that always sticks in my head was a UK bank, I think it was standard chartered That was having a run on its deposits during the 2008 credit crisis. And at one point, the chancellor of the exchequer came out and said, we guarantee full faith and credit that deposit all UK depositors in this bank. And, you know, what happened the next day, the run got even larger and, and so, you know, that’s not rational, but I think you know we know how people behave and I think because of that, people worry

[0:47:47 Speaker 1] so is it safe to say that this is an experiment the Fed did not want to run because they didn’t want to see the counterfactual and the risk of the counterfactual being terrible was too great.

[0:47:57 Speaker 0] I can’t you know, look, I can’t obviously can’t speak for the Fed, but it wouldn’t surprise me if that was certainly a consideration. They looked at the degradation in the markets and rather than let things spread and you know, having to commit more capital. Three weeks later they committed what they committed. It got some moderate use. It wasn’t heavily used. But if you look at their report, you can see what’s big effect was at the announcement at the at the start of the facility, pretty much redemption ceased spread, started to come back into line. And just the mere existence of that liquidity facility, that backstop facility was enough to calm the markets.

[0:48:36 Speaker 1] Something through the reforms made after the global financial crisis made money market funds more vulnerable, especially reforms targeting the first mover advantage like fees and Gates and Fed Governor Brainerd actually gave a speech last week. And in that speech quote, she said, if properly calibrated capital buffers or reforms that address the first mover advantage to investors that redeem early, such a swing pricing or a minimum balance at risk could significantly reduce the run risk associated with money funds. What do you think about her remarks?

[0:49:05 Speaker 0] You know, so, so there’s capital buffers that you mentioned, you mentioned minimum balance at risk and you mentioned swing pricing. So these are all very different things. The idea of a capital buffer is, you know, that that’s not, that’s a bank like regulatory solution. So asset managers typically don’t need to have capital in a fund itself, a pool vehicle doesn’t have a set aside pool of capital, it’s an agency vehicle. You issues us generally a single class of shares. All the money is at risk. The idea of a capital buffers is a bank like approach to this. You’re going to set aside some amount of money funded by someone and it’s going to be there in the event of a liquidity shortfall. That’s a very bank like solution. I think, you know, if one is to approach things that way, One of the questions you’ve got to ask yourself is who’s going to contribute the money to the capital because they’re going to want a rate of return on that somehow. And you know, so there’s going to be some design features there and in the end the shareholders have to pay for that so that there will be a set of questions around that. I think swing pricing is an interesting one. So the idea of swing pricing and swing pricing is used in europe for certain facilities is that when people redeem their shares, you can redeem that them at some price other than than current nav, so you can assign a bit of a haircut to their shares and make them bear the cost of their redemptions. And this is done continuously. So, you know, if people are starting to redeem and maybe you have the onset of a crisis, you might haircut those shares if you’re deeper in the crisis and liquidity is more diminished again, you haircut the shares, so you make the parties who are involved in the redemption bear the costs of their redemptions. Of those two approach, I think I would look more favorably toward the swing pricing than I would the capital buffer. It makes a little more sense to me, especially within the context of asset management. We also have a history of it being used in other parts of the world.

[0:51:12 Speaker 1] There was another presidential working group report issued in december. The sec has requested comment on potential future reform. One of the recommendations to consider if I’ve read it properly is just to codify the existence of a credit facility that would up in, you know, from the Federal Treasury during times like this. Is that a is that a good economic decision?

[0:51:40 Speaker 0] Well, you know, so so this is this is, you know, economists have a language for things like this. If if everybody knows that when you get in trouble, a thing is going to pop up to bail you out, then that can change people’s behavior in the first instance. Um, So there may be moral hazard involved in that. So, so that’s certainly a consideration. Now, someone could say de facto we have that anyway. When something happens, that’s exactly what we’ve got in some sense. This is a question of how, how Treasury and how you want, you know, the Treasury and fed, how they want to run their affairs. It seems like at least we’ve got a few instances now that show that when markets get impaired, these funds are challenged in terms of liquidity, they may hold money, good assets. That is, there may not be a challenge in terms of the value of the claims on their balance sheet. But that doesn’t mean that people won’t get concerned about their ability to get their, their, their claims back in a timely manner. So, you know, I’m not sure I can speak to whether that’s a great idea or not, but I can think of some, some knock on effects that will almost certainly have

[0:52:47 Speaker 1] you bring up an important point, that there may just be this creeping perception that the bailout just implicitly exists across the board. And maybe one manifestation of that is you very rarely hear discussions about too big to fail anymore. And I wonder if that’s because this hypothesis you just presented or be did the reform solve the too big to fail problem?

[0:53:10 Speaker 0] Yeah, that’s a that’s a good question. I mean, we still have some very, very large money funds out there. Um, and, you know, the the largest ones are going to hold government paper. They’re gonna hold very, very high credit quality paper, but you have to believe that if there were a liquidity problem associated with them, somebody you would hope somebody would step in, and, and, um, you know, I think with the, you know, 2000 and eight and in 2000 and 20 we’ve seen instances where it’s very clear that the Fed’s going to step in if they think the financial systems in peril, and I’m not sure, I’ve seen anything that that makes me think that’s going to change in the future.

[0:53:46 Speaker 1] Do you think that potential reforms with money market funds surrounding the ideas like capital buffers? Is that, in your opinion, better under the purview of the Fed, instead of the sec?

[0:53:57 Speaker 0] You know, the sec is not really in that kind of a business. They are not a prudential regulator. They don’t typically deal with those kind of issues. So, for example, it’s not the subject of our discussion. But think about broker dealers, we don’t run our broker dealer regulatory system to make sure that broker dealers stay in business if they get in trouble regulatory framework pretty much says we got a whole lot of broker dealers out there if they get in trouble. What we care about is that customers get their money back, people who are owed money, especially customers, get their money back, and that the broker dealer unwind in somewhat orderly and sensible manner. That’s our regulatory framework very different than the framework for a prudential framework or the framework for a bank. When people talk about safety and soundness, asset managers, same type of thing, we don’t we don’t have a framework to put capital into an asset manager. It’s an agency framework. We just make sure that conflicts of interest are solved, that the incentives are clear, that the disclosure is good. That’s the general approach. And it’s not one of ensuring the resilience per se or the the pool maintain its value or that continue into the future. That’s just not our approach.

[0:55:14 Speaker 1] So we’re getting close to end of our time here and we’ve talked about a lot and covered a lot. And before we end, I’d like to ask you the perhaps again, an unfair question. But if you were back at the S. E. C. And you’re making the decision of what to do going forward. I mean, where do you think the reform should land and how should we treat money market funds going forward?

[0:55:34 Speaker 0] You know, it’s a tough question. And the reason why it’s tough is I’m sympathetic to the bank regulators who say, you know, we’ve had a couple stresses in the last 20 years and we’ve had to step in, but we don’t have a seat at the regulatory table really. So I’m sympathetic to them. On the other hand, you know, I think money market funds as a product have provided important competition to the banks. I think that they’ve given consumers choice. And so I would not favor a solution that caused these things not not become viable businesses, at least at the moment. I would like to see them continue as a business because I think as a product, consumers are better off. It may be that, you know, we we need to think a little more carefully about how to get them to bear the full cost of their liquidity guarantee. Okay, I think that’s a fair argument then we can talk about how to do that. But I would hate to see a world where money market funds were, not around 10 years from now.

[0:56:31 Speaker 1] So I guess the answer is we’re going to treat it like other systematic problems and markets like credit rating agencies where they serve a purpose, but there are always problematic and we just have to continuously recalibrate how we deal with them.

[0:56:45 Speaker 0] Credit rating agencies. Now there is a hard problem. Yeah, I’ve at some level at some level I hopefully we can get a little better on it. I mean you look the floating now, there’s probably a step in the right direction. We’re clearly not there.

[0:57:01 Speaker 1] Great. Well eric we really appreciate your time with us today and uh thanks again.

[0:57:07 Speaker 0] My pleasure is good to be here.

[0:57:09 Speaker 1] We hope you enjoyed this episode and if so, please rate it so that others can find it. The production is brought to you by the Salem Center for Policy Housing, The McCombs School of Business at the University of texas at Austin. If you’d like to learn more about the center visit Salem center dot org. Our student executive producers from the moody’s College of Communication or Abby Sawyer and Zoe